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Wednesday, May 5, 2010

Transocean Oversold?

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Guest Authors

Value investors often look for opportunities where temporary circumstances have caused the market to unjustifiably depress prices. One such value-minded investor, Frank Voisin, may have uncovered such an opportunity. The following is a guest post where Frank makes his case for Transocean Ltd, a company whose stock has been punished as the massive oil leak on the Gulf of Mexico continues.

Transocean Ltd (RIG) is an international provider of offshore contract drilling services for oil and gas. Transocean is the largest such operator, with 138 mobile offshore drilling units, including 44 high-specification floaters which command the highest day-rates for use in the deepest, harshest drilling environments, 26 mid-water, 65 jack-ups, and 3 others.

On April 20, 2010, a Transocean rig leased to BP plc (BP), the Deepwater Horizon, suffered an explosion and sank two days later. The Deepwater Horizon was in the final stages of casing a well (adding a cement reinforcement liner to the well) when the explosion took place. The well was approximately 1 mile beneath the ocean surface, and extended approximately 5 miles underground. The explosion appears to have been the result of the cement casing not being fully cured, resulting in the release of a massive amount of pressure from the oil reservoir up through the well. Explosions of this sort are supposed to be prevented by a Blow-Out Preventer, a massive device (16m wide) with up to 12 different fail-safe mechanisms that can be manually activated to close over the well to prevent leaks and withstand the pressure. In this case, the Blow-Out Preventer was designed and built by Cameron International Corp (CAM).

The market appears to be expecting losses from this disaster to exceed a present value of $30 billion. This is based on the fact that BP, Transocean and Cameron have suffered market cap reductions of $25 billion, $5 billion and $1 billion respectively.

To put this in perspective, the Exxon Valdez disaster in Prince William Sound, Alaska, which, in 1989 resulted in 250,000 barrels being spilled, led to a jury award (in Baker v. Exxon) of $287 million actual damages + $5 billion punitive damages. The Deepwater Horizon disaster would have to continue, at a rate of 5,000 barrels per day (the current official estimate), for nearly two months to yield the same oil spillage as the Exxon Valdez, and the market would still be pricing a loss equal to 6x the Exxon Valdez.

It is important to note that the original $5,287m loss expected for the Exxon Valdez disaster was subsequently reduced to approximately $500m, and this was paid out 19 years later after substantial litigation, when the Supreme Court of the United States ultimately limited punitive damages to a 1:1 ratio with compensatory damages. At a 10% discount rate, this translates to a 1989 Present Value of less approximately $81m.

Based on the quantum of damages ultimately awarded in Exxon Valdez, and the relative size of the Exxon Valdez disaster to the Deepwater Horizon, we would expect the present value of future losses to be substantially smaller. However, the fact that the Deepwater Horizon disaster took place in a more heavily populated area of greater economic significance could support an argument that future losses will be substantially higher. For the sake of conservatism, we can assume the losses are substantially higher – closer to the amount the market is currently pricing ($30b) and now turn to loss apportionment to determine who would be responsible for these losses.

There are at least three categories of expenses associated with the disaster:

My investigation has led me to conclude that Transocean will be responsible for the first two categories, and that BP will be responsible for the third category.

Transocean is fully insured for the loss of the Deepwater Horizon. The rig has an estimated replacement cost of $700m. Transocean’s 2009 Annual Report shows that it has a deductible of up to $1.5m on the loss of any rigs, and that is has a $10m-per-occurrence deductible on crew personal injury liability and $5m-per-occurrence on other third-party non-crew claims. These deductibles are for a $950m third-party liability coverage exclusive of the personal injury liability. Transocean is reputed to also have $700m in environmental remediation insurance. Thus, Transocean is fully insured for the first two categories, and partially insured for the third.

Given that Transocean is fully insured for the first two categories, the market appears to be pricing in a loss of approximately $5b above the $700m environmental remediation insurance cap. Will Transocean be responsible for environmental remediation? The answer appears quite clearly to be no, and that BP will be responsible for environmental remediation both due to common law, statutory law, and contract law.

Common Law

Under Maritime Common Law, there is an Anchored Tanker precedent, which states that the owner of an anchored tanker is liable for any damage resulting from it, even if that tanker is hit by another ship that was behaving in a reckless or negligent manner. BP, as the lessee of the Deepwater Horizon, is the owner of the anchored tanker, in this case.

Statutory Law

After Exxon Valdez, the US government passed the Oil Pollution Act, which clearly shows liability for the environmental damage to be BP’s responsibility.

Section 1002(a) of the Oil Pollution Act states that the “responsible party” for a facility from which oil is discharged is liable for removal costs and other specified damages.

Section 2701(32)(c) of the Oil Pollution Act states that the “responsible party” means, in the context of offshore facilities, the lessee of the area in which the facility is located, or the holder of a right to use and easement granted under the Outer Continental Shelf Lands Act.

Thus, BP, as the lessee of the facility, is the responsible party, and as such is liable for removal costs under statutory law.

Contract Law

With respect to contract law, various reports online state that a typical drilling contract used in the offshore drilling industry specifies that the lessor (Transocean) is not liable for blowouts. All liability in such situations is the responsibility of the lessee (BP), and that the lessee (BP) will indemnify the lessor (Transocean) even if they are shown to be reckless, negligent, or had behaved with gross misconduct. There has been no evidence presented to suggest that BP and Transocean did not use a standard contract. Given BP’s initial attempts at deflecting blame, it would seem that such an obvious opportunity to point blame at Transocean would have been utilized if available. Given that it was not utilized, I conclude that it is unlikely the contractual relationship between the parties contains anything out of the ordinary.

What The Involved Parties Are Saying

On April 29th, during a previously scheduled analyst call to discuss 2010 Q1 earnings, BP’s CFO, Byron Grote said the following:

"As far as the Gulf of Mexico goes, you asked about contracts, I believe are a kind of code word for here for where does liability lie. … [I]n general, Transocean was responsible for the operation of the rig vessel and its equipment including the blow-out preventer and for drilling the well. In general, the lease owner that’s BP and our partners in the field, are responsible for the cause of regaining control over the well and handling the related environmental cost."

On May 3rd, BP’s CEO, Tony Hayward told Good Morning America his company is “absolutely responsible” for the cleanup.

Transocean does not have insurance for loss of revenue associated with a lost rig. In September 2009, BP extended its lease of the Deepwater Horizon for an additional three years, for $544 million, which equates to approximately $181m per year. This is approximately 1.66% of Transocean’s 2009 revenue. Assuming for simplicity that this represents a similar portion of earnings, this translates to a decrease in earnings of approximately $53m. Using a 9x P/E multiple (the approximate multiple being used prior to the explosion), this should have wiped $477m off of Transocean’s market cap.

Instead, the market priced in 10x this amount. This appears to be an overreaction. This would be the maximum rational drop in market cap, however this figure is mitigated by two items:

1) One of the potential solutions to the continuing leak is to drill new wells into the old well, deep below the ocean floor, and inject cement into the original well. This process could take several months, and BP has begun drilling already. Media reports state that BP has hired Transocean rigs to drill these new wells, which would indicate that Transocean’s loss of revenue will be mitigated to some extent.

2) Since the Deepwater Horizon disaster, the price of oil increased from $84/barrel to $88/barrel. If this is due to the disaster itself, then this would be a persistent increase. Persistent increases in the price of oil have translated to higher dayrates, especially amongst higher specification rigs. Transocean has some of the most sophisticated rigs in the world, and may ultimately be able to charge higher dayrates on its other rigs, which would mitigate the loss of revenue from this one rig.

Conclusion

It appears that all of the parties involved, as well as numerous analysts and commentators, are confirming what the law states: BP will be responsible for environmental remediation, which will constitute the vast majority of expenses relating to this disaster. For those expenses which Transocean is responsible for, Transocean is adequately insured. With regard to the loss of revenues, the ultimate loss, regardless of how liberal they are expected to be, seems to be dwarfed by the amount the market is pricing into Transocean’s current market cap. There appears to be little by way of justification for such a decrease.

The market is being overly pessimistic with Transocean. I expect shares to return to their previous 9x multiple in the near future.

8 comments:

Stock hasn't sold-off solely due to fear of liability or litigation. NE and DO are off 16.5% and 11.7% vs. 18.1% for RIG. Not saying it isn't oversold but considering their best comps are also off a considerable amount it seems that the sell-off is not solely (or even primarily) due to liability

It appears the whole industry is getting hammered without regard to whether they have much exposure to the Gulf, as part of the market's overreaction to the event in general.

I understand why HAWK would be beaten down - if the US gov halts future production in the Gulf, HAWK is essentially a no-growth annuity until its current contracts run out. But NE, DO, RDC shouldn't be hit like this with the exposure they have!

As Frank points out perhaps the sell-off has been because of the expectation that Gulf coast drilling will see some weakness going forward. RIG's ultra deep water floaters (UDWF's) have 50% exposure to the gulf coast, and their future deployable UDWF's also have high exposure to gulf coast. Maybe they will get contracted to Brazil but right now these are the highest day rate rigs in their arsenal and have some regulatory overhang.

My guess is (as tgoc99 pointed out) that the overhang of reduced drilling activity in the gulf might be a concern for the group.